Discover how to trade relative strength with these two powerful stock market indicators.
RSI
If you’re unfamiliar with stock indicators, RSI, or the relative strength index, is a great place to start. A popular momentum indicator, RSI uses an oscillator to delegate stocks with a value between 0 and 100.
Vocab Check:
Oscillator: A line graph that moves up and down between two extremes (in this case, between 0 and 100)
Momentum Indicator: Technical indicators like RSI, relative strength, MACD, and Stochastic Oscillators are all methods of analyzing the strength, speed, and size of a stock’s move.
The 30/70 Rule
Traders use RSI to determine whether an equity is overbought or oversold in a particular time frame. As the price of the asset rises and falls, so does the RSI — which is commonly read like this:
- Trading below 30 indicates that an asset is oversold, and could be ready for a bounce.
- Trading above 70 indicates that an asset is overbought, and could be ready for a pullback.
However, many chartists and traders have their own set of rules about the RSI. For instance, CMT Constance Brown preaches that if a stock is in an uptrend, an oversold reading is likely higher than the standard 30% — and likewise, if a stock is in a downtrend, an overbought reading is likely much lower than 70%.
As you continue to study RSI, you will likely come to your own conclusions and develop your own nuances about this popular indicator. But the 30/70 rule is a great place to start.
Time Frames
The readings from the RSI will vary depending on the time frame being viewed. Shorter time frames can present more ‘opportunities’ — more tradeable moments, but they can also present more ‘noise’ — meaning that each individual reading can be less reliable. As a rule of thumb, it’s best to lean on the time frame that you intend to be in the trade.
For instance, if you’re a day trader (intending to get in and out within the same day, buying and selling tiny bounces or pullbacks in an equity), you should be working most closely with the one-day RSI.
If you’re a swing trader and plan to be in the trade for weeks or even months, you might consider using a broader month time frame.
How It Works In Practice
Let’s use the Apple ($AAPL) 1-month RSI as an example of how you could have used overbought and oversold signals to trade bounces and pullbacks in this name.
Using a 1-month time horizon, Apple surpassed an RSI of 70 two times — leading it to be “overbought”. In the first instance (April 29th, 2022) while trading at $165.98, Apple reached an RSI of 71.53. Immediately, the price began to crumble, falling 7.3% to $153.86 within just 3 trading days.
Interestingly, that was when Apple became “oversold”, with an RSI that dropped below 30. That triggered a short-term bounce back of 6.6%, sending the price back up to $166.04, and an RSI of 78.17. You know the drill: Apple drilled – from $166.04 all the way down to $139.60.
As you can see in the chart above, RSI doesn’t always work out this perfectly. On May 12th, Apple’s RSI reached 15.80, the stock bounced quickly, and then fell back to an oversold reading once again on the same day. While Apple did recover about 10 points after that reading, it only reached an RSI of 62.23 (not technically oversold) before taking its next leg down.
What does this tell us? That RSI is one important tool for any trader to get a bigger picture about the price action in a particular asset — but it isn’t the only tool to do this.
RSI vs Relative Strength
We know, it sounds confusing, but technically relative strength refers to a different measurement than the RSI.
While RSI allows traders to measure potentially overbought or oversold conditions in an equity, relative strength measures an equity’s performance compared to its peers.
For instance, if a stock is outperforming its sector (or a close competitor, or the market in general), it is considered to have high relative strength.
Here’s an example of a few ways you might measure YTD relative strength in Apple ($AAPL):
Apple Versus the Invesco QQQ Tech ETF, YTD
In this example, Apple has more relative strength than the popular tech ETF, $QQQ (which is 11.02% Apple stock).
In this example, Apple has more relative strength than the popular tech ETF, $QQQ (which is Apple Versus the FAANG Complex, YTD
While many of the companies in FAANG are not direct competitors to Apple’s business model, the stocks are often placed in the same “genre”. For that reason, it can be helpful to know which of these big tech behemoths have the highest relative strength. In this case, it is Apple that comes out on top, with Netflix taking the bottom spot.
Now, let’s take a broader view:
Apple Versus The Vanguard Total Market ETF, YTD
In this example, we see that year-to-date, Apple has underperformed the $VTI ETF (which seeks to be a measure of all stocks), meaning it has a low relative strength when compared to the broader market.
Putting this data together, we can ascertain that year-to-date, Apple has high relative strength in comparison to its FAANG peers. However, when you open up the comparison to the broader market, Apple still has a lower relative strength than most stocks in 2022.
Of course, if you zoom out to a one-year view rather than a year-to-date view, the story changes once again.
Apple Versus $VTI and $QQQ, 1YR
The Bottom Line
So after reading this, you may have some questions. Questions like, “why so many charts?”, “why so many different ways to measure relative strength?”, and “which measure is most effective?”
The answer to all three: More data makes you a better-equipped trader. By combining these indicators, and absorbing all of the charts & time frames, you can get a much better picture of the performance of an asset.
For instance, in the example above, if you just looked at Apple YTD, you would see a stock that was down 21.64%. By examining its tech peers and the market as a whole, you get a broader picture — it isn’t an Apple problem, it’s a macro problem.
And then, by zooming out and viewing it from a different time frame, you illuminate the picture even more: it isn’t common for Apple to underperform like it did YTD.
Finally, by viewing the RSI through multiple time frames, you can start to determine a suitable entry point — if you were planning to make a trade, that is.
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